[Joint House and Senate Hearing, 112 Congress]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 112-191
 
                      WHAT IS THE REAL DEBT LIMIT?

=======================================================================

                                HEARING

                               before the

                        JOINT ECONOMIC COMMITTEE
                     CONGRESS OF THE UNITED STATES

                      ONE HUNDRED TWELFTH CONGRESS

                             FIRST SESSION

                               __________

                           SEPTEMBER 20, 2011

                               __________

          Printed for the use of the Joint Economic Committee




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                        JOINT ECONOMIC COMMITTEE

    [Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]

SENATE                               HOUSE OF REPRESENTATIVES
Robert P. Casey, Jr., Pennsylvania,  Kevin Brady, Texas, Vice Chairman
    Chairman                         Michael C. Burgess, M.D., Texas
Jeff Bingaman, New Mexico            John Campbell, California
Amy Klobuchar, Minnesota             Sean P. Duffy, Wisconsin
Jim Webb, Virginia                   Justin Amash, Michigan
Mark R. Warner, Virginia             Mick Mulvaney, South Carolina
Bernard Sanders, Vermont             Maurice D. Hinchey, New York
Jim DeMint, South Carolina           Carolyn B. Maloney, New York
Daniel Coats, Indiana                Loretta Sanchez, California
Mike Lee, Utah                       Elijah E. Cummings, Maryland
Pat Toomey, Pennsylvania

                 William E. Hansen, Executive Director
              Robert P. O'Quinn, Republican Staff Director


                            C O N T E N T S

                              ----------                              

                     Opening Statements of Members

Hon. Kevin Brady, Vice Chairman, a U.S. Senator from Texas.......     1
Hon. Jim DeMint, a U.S. Senator from South Carolina..............     1
Hon. Elijah E. Cummings, a U.S. Representative from Maryland.....     3

                               Witnesses

Dr. Allan H. Meltzer, The Allan H. Meltzer University Professor 
  of Political Economy, Carnegie Mellon University, Pittsburgh, 
  PA.............................................................     5
Mr. Chris Edwards, Director of Tax Policy Studies, Cato 
  Institute, Washington, DC......................................     7
Dr. Laurence Ball, Professor of Economics, Johns Hopkins 
  University, Baltimore, MD......................................     9

                       Submissions for the Record

Prepared statement of Representative Kevin Brady.................    28
    Chart titled ``Total U.S. Government Spending = 41% of GDP 
      (2011)''...................................................    30
    Chart titled ``Rise in Fed's Treasury Holdings Accounts for 
      More Than One-Third the Rise in U.S. Debts Since March 
      2009''.....................................................    31
    Chart titled ``What is the Tipping Point?''..................    32
    Chart titled ``Gross Government Debt as a Percent of GDP''...    33
    Chart titled ``Federal Reserve Balance Sheet = $2.9 
      Trillion''.................................................    34
    Chart titled ``Long Term Budget Outlook; Debt to GDP Ratio''.    35
Prepared statement of Dr. Allan H. Meltzer.......................    36
Prepared statement of Mr. Chris Edwards..........................    39
Prepared statement of Dr. Laurence Ball..........................    48


                      WHAT IS THE REAL DEBT LIMIT?

                              ----------                              


                      TUESDAY, SEPTEMBER 20, 2011

             Congress of the United States,
                          Joint Economic Committee,
                                                    Washington, DC.
    The committee met, pursuant to call, at 10:04 a.m., Room 
210, Cannon House Office Building, the Honorable Kevin Brady, 
Vice Chairman, presiding.
    Senators present: DeMint.
    Representatives present: Brady, Burgess, Campbell, 
Mulvaney, and Cummings.
    Staff present: Connie Foster, Robert O'Quinn, Michael 
Connolly, Rachel Greszler, Gail Cohen, Will Hansen, Colleen 
Healy, and Jesse Hervitz.

 OPENING STATEMENT OF HON. KEVIN BRADY, VICE CHAIRMAN, A U.S. 
                   REPRESENTATIVE FROM TEXAS

    Vice Chairman Brady. Good morning, everyone. Welcome to the 
Joint Economic Committee hearing. The topic is, ``What is the 
Real Debt Limit?'' We so appreciate the panelists we have here 
today.
    And I want to commend Senator DeMint, who leads Senate 
Republicans on the Joint Economic Committee, for spearheading 
this hearing on this very important and timely topic. And I 
would yield to Senator DeMint for the opening statement.

OPENING STATEMENT OF HON. JIM DEMINT, A U.S. SENATOR FROM SOUTH 
                            CAROLINA

    Senator DeMint. Thank you, Mr. Chairman. And I appreciate 
all of your work and your staff's work to put this together.
    And I want to thank all of our panelists for taking their 
time to be here.
    A couple of months ago in Washington, everyone was in a 
panic of what might happen if we couldn't borrow any more 
money. And the President mentioned we might not be able to pay 
Social Security. We talked about reneging on payments to 
contractors. We talked about a pretty dire situation if the 
United States could not borrow any more money.
    But that debt limit was an arbitrary debt limit set by 
Congress, one that we could change by a simple debt-limit deal. 
My concern and I think that a number of Americans is, where is 
the real debt limit? When do we hit the wall where no one will 
lend us any more money and perhaps the Feds can't even print 
enough money? At what point is there not enough credit in the 
world to continue to finance not only the United States but all 
the debtor nations?
    You know, under CBO's alternative budget forecast, their 
model essentially stops working in the early 2040s because of 
excessive U.S. debt. I just want to look at a couple of charts 
here of where we see the debt going relative to the GDP. There 
is no way we are going to get that far. My concern is, can we 
borrow another 2\1/2\ trillion? The Federal Reserve is 
apparently buying a lot of our debt already. Is there still a 
market for the kind of debt that the United States needs to 
sell?
    Despite the commitment to reduce our deficit--and, again, 
``deficit'' is a Washington term, the year-to-year shortfall--
we have said we would reduce that year-to-year shortfall $2.1 
trillion over the next 10 years, giving the impression to 
Americans that we are actually lowering the debt, when, as I am 
sure all of our panelists know, we are going to continue to 
increase the debt. It may be $8 trillion, $10 trillion; we are 
not sure. But, again, if we look at our charts, I am not sure 
we can borrow that much money.
    But if we look here, at what we are trying to discover 
today, or determine, or guess at: Where is the tipping point 
for America beyond which the interest rates will rise sharply, 
economic growth will decline dramatically? As we look at the 
potential tipping point for Greece and Ireland and Portugal and 
U.S. as a percent of GDP, we see the United States is right 
there where these other nations are. Is the only thing that 
makes us different that we can print money and that we are the 
world's reserve currency? These other countries can't print 
their own. But hopefully our panelists will help us sort this 
out.
    And what does the United States look like once we reach 
that tipping point, when we hit a very real debt limit? How 
high will interest rates go? What will be the borrowing cost if 
we can, in fact, borrow the money? Will the Fed just print 
money? These are things we are trying to anticipate.
    The Fed is clearly engaged in unprecedented action, 
including the purchase of trillions of dollars of U.S. 
Treasuries and mortgage-backed securities. You know, since the 
financial crisis in 2008, the Fed's balance sheet has tripled 
to $2.9 trillion. We can see here what the Federal Reserve has 
done, with very little notice by Congress, which effectively 
means we are printing money and buying debt.
    So how could the Fed's policies affect the tipping point? 
What can we expect? There are a lot of questions. And, 
certainly, we need to know, how long can the Federal Reserve 
monetize our debt before the world begins to lose confidence in 
our currency?
    So my challenge to the panelists today is that, all 
politics aside, all partnership aside, our country is drowning 
in debt. The plan by this government is to continue borrowing 
money for the foreseeable future. Any talk of balancing the 
budget is considered extreme. What does that mean for our 
country? How much time do we have, and what is going to happen 
when we can no longer borrow money?
    Thank you, Mr. Chairman.
    Vice Chairman Brady. Thank you, Senator.
    The chair recognizes Representative Cummings for an opening 
statement.

     OPENING STATEMENT OF HON. ELIJAH E. CUMMINGS, A U.S. 
                  REPRESENTATIVE FROM MARYLAND

    Representative Cummings. Thank you very much, Mr. Chairman.
    I want to thank you, Vice Chairman Brady, for calling 
today's hearing to examine the effects of the national debt on 
our broader economy.
    I welcome our witnesses and extend, particularly, a warm 
welcome to Dr. Laurence Ball, professor of economics at Johns 
Hopkins University. And Johns Hopkins, of course, is located in 
Baltimore and smack-dab in the middle of my district.
    Last week, the Director of the Congressional Budget Office 
testified before the new Joint Select Committee on Deficit 
Reduction. He reported that if we proceed under current law--
for example, allowing the Bush tax cuts to expire at the end of 
this year--by 2021 debt held by the public will equal 61 
percent of GDP, well above the annual average of 37 percent 
recorded between 1971 and 2010. Under the CBO's so-called 
``alternative baseline,'' in which the Bush tax cuts and the 
AMT patch are extended and other current policies continue, 
debt held by the public is expected to balloon to nearly 190 
percent of GDP by 2035.
    The Director testified that, notwithstanding the latest 
long-term projections under the so-called Budget Control Act, 
interest payments on the debt and lost confidence in our 
ability to manage our budget would create a clearly 
unsustainable scenario. However, the CBO Director also told the 
committee that there is no inherent contradiction between using 
fiscal policy to support the economy today and imposing fiscal 
restraints several years from now. He instructed, if we want to 
achieve both a short-term economic boost and longer-term fiscal 
sustainability, a combination of policies would be required: 
changes in taxes and spending that would widen the deficit now 
and reduce it later in the coming decade.
    Thus, the CBO Director confirms what countless economists 
have been warning Congress about. Draconian spending cuts will 
not generate the economic growth we need now, right now, to put 
Americans back to work and enable them to compete and succeed. 
Moreover, such harmful cuts are unnecessary to rein in the debt 
and will only serve to slow our already tepid growth, 
ultimately reducing revenues coming in through taxes.
    In fact, one of the major causes of our current budget 
deficits, and, thus, a major cause of the growing debt, is our 
continued slow economic growth. The recession that started in 
2007 is responsible for more than $400 billion of our annual 
deficits between 2009 and 2011, according to the Center for 
Budget Policies and Priorities and the CBO. Therefore, one of 
the most effective steps we could take to tackle the debt right 
now is to start growing the economy again, which is also what 
the American people desperately need and desperately want.
    According to Laura Tyson, chairwoman of the Council of 
Economic Advisers and the National Economic Council in the 
Clinton Administration, which presided over one of the most 
sustained periods of economic growth and job creation in our 
Nation's history, investments in infrastructure, job training, 
and research and development, which would address the immediate 
jobs gap and foster future growth, would help reduce the 
deficit. An extra percentage point of growth over the next 5 
years would do more to reduce the deficit during that period 
than any of the spending cuts currently under discussion. And 
over the next decade, an extra percentage point of growth would 
add about $2.5 trillion in revenue.
    While this hearing is aimed at examining the impact of the 
Federal debt on our economy, I would submit that, at present, 
the debt is a nominal factor in our current economic outlook. 
Rather, slowed hiring, low consumer confidence and demand, 
skills mismatches between workers and jobs, reduced public 
investment, and the continuing foreclosure crisis are driving 
our economic conditions and our rising debt, rather than the 
other way around.
    Finally, until we recognize this reality and move to tackle 
these challenges, an exclusive focus on the debt crisis will 
essentially consign our Nation to chasing our economic tail--a 
wholly unnecessary and unproductive exercise. However, I 
anxiously look forward to hearing from our witnesses. I thank 
you all for being here today.
    And, with that, Mr. Chairman, I yield back.
    Vice Chairman Brady. Thank you.
    Two housekeeping notices. One, the clocks are not working, 
so we will be keeping the time manually. And we will make 
notice of that as we come up to the 5-minute time limit for 
both testimony and questions.
    Also, I have an opening statement I would like unanimous 
consent to insert into the record, without objection.
    [The prepared statement of Representative Kevin Brady 
appears in the Submissions for the Record on page 28.]
    [Chart titled ``Total U.S. Government Spending = 41% of GDP 
(2011)'' appears in the Submissions for the Record on page 30.]
    [Chart titled ``Rise in Fed's Treasury Holdings Accounts 
for More Than One-Third the Rise in U.S. Debts Since March 
2009'' appears in the Submissions for the Record on page 31.]
    [Chart titled ``What is the Tipping Point?'' appears in the 
Submissions for the Record on page 32.]
    [Chart titled ``Gross Government Debt as a Percent of GDP'' 
appears in the Submissions for the Record on page 33.]
    [Chart titled ``Federal Reserve Balance Sheet = $2.9 
Trillion'' appears in the Submissions for the Record on page 
34.]
    [Chart titled ``Long Term Budget Outlook; Debt to GDP 
Ratio'' appears in the Submissions for the Record on page 35.]
    Vice Chairman Brady. And the chair yields to Senator DeMint 
for introduction of the panelists.
    Senator DeMint. Okay. Thank you, Mr. Vice Chairman. It is 
my privilege to introduce our three distinguished witnesses to 
provide testimony on this matter of such enormous importance to 
the American people and to the future health of our economy.
    Our first witness, Dr. Allan Meltzer, is currently a 
professor of political economy and public policy at the 
Carnegie Mellon University's Tepper School of Business in 
Pittsburgh, Pennsylvania. He has previously served as a member 
of the President's Economic Policy Advisory Board, an active 
member of the President's Council of Economic Advisers, and a 
consultant to the U.S. Treasury Department and the Board of 
Governors of the Federal Reserve System.
    In 1999 and 2000, he served as the chairman of the 
International Finance Institution Advisory Commission, which 
was formed by Congress to review the role of the International 
Monetary Fund, the World Bank, and other world financial 
institutions. He is the author of numerous books on economic 
theory and policy, including a multivolume ``History of the 
Federal Reserve.''
    Dr. Meltzer received his B.A. from Duke University and an 
M.A. and Ph.D. in economics from the University of California 
at Los Angeles.
    Next, we will be hearing from Mr. Chris Edwards, who is 
currently the director of tax policy studies at the Cato 
Institute and editor of Cato's Web site, 
DownsizingGovernment.org.
    Before he began his work at Cato, he was senior economist 
for the Joint Economic Committee, as well as an economist for 
the Tax Foundation from 1992 to 1994. He is also the author of 
``Downsizing the Federal Government'' and co-author of ``Global 
Tax Revolution.''
    Mr. Edwards holds a B.A. and an M.A. in economics.
    Our final witness is Dr. Laurence Ball. Dr. Ball is a 
professor of economics at Johns Hopkins University. He 
previously taught at Princeton University and New York 
University. Dr. Ball has done extensive research and writing on 
a variety of economic topics, including the foundations of 
Keynesian economic models. He has done in-depth studies of 
inflation and monetary policy in both the United States and in 
high-inflation countries, with a specific focus on how best to 
reduce inflation and the economic cost of inflation.
    Dr. Ball is currently a research associate at the National 
Bureau of Economic Research. He was previously a lecturer at 
the IMF Institute, a member of the Federal Reserve Board's 
Academy Advisory Panel, and a consultant on the International 
Monetary Fund's World Economic Outlook.
    Dr. Ball holds a B.A. in economics from Amherst College and 
a Ph.D. in economics from Massachusetts Institute of 
Technology.
    It is an honor to have all of you here today and to benefit 
from your expertise on this subject.
    Vice Chairman Brady. The chair recognizes Dr. Meltzer.

    STATEMENT OF DR. ALLAN H. MELTZER, THE ALLAN H. MELTZER 
  UNIVERSITY PROFESSOR OF POLITICAL ECONOMY, CARNEGIE MELLON 
                   UNIVERSITY, PITTSBURGH, PA

    Dr. Meltzer. Thank you, Mr. Chairman. Thank you, Vice 
Chairman Brady, Senator DeMint, members of the committee. It is 
a pleasure to appear before the Joint Economic Committee.
    My association with this committee goes back to the days of 
Senator Paul Douglas. It was Senator Douglas who pushed and 
prodded the Federal Reserve to stop holding interest rates 
fixed and to permit monetary policy to do much more to prevent 
inflation. His views eventually prevailed. That should remind 
the Members of their responsibility.
    Today I will answer the questions that the hearing seeks to 
answer. They are good questions that show the rising concern 
for the consequences of recent Federal Reserve actions. I will 
introduce my answers with my explanations of why Federal 
Reserve policy is misguided and mistaken, inflationary and 
inappropriate. There are several reasons; I will give three.
    First, in writing the three volumes of ``A History of the 
Federal Reserve,'' I read more minutes and transcripts than any 
person can endure. With very rare exceptions, notably in the 
years when Paul Volcker led the disinflation policy, one looks 
in vain for a statement of the medium-term consequences of the 
actions taken at the meeting. True, the staff and others 
provide forecasts of the future, but the FOMC never tries to 
reach agreement on the consequences of its actions for the 
public. It publishes forecasts, but there is no clear relation 
between the forecasts and the actions.
    Second, concerns at FOMC meetings are mainly about the near 
term. The Federal Reserve has little influence over what will 
happen in the near term but much greater influence on the 
medium term. The present is characteristic. The Fed Chairman 
and some of the members seem determined to, quote, ``do 
something,'' end quote, more about the excessive waste and the 
harm of high unemployment. They neglect the fact that there is 
no shortage of money and liquidity and that they have pushed 
and prodded market interest rates to the lowest levels ever 
achieved anywhere.
    The United States does not have a problem of too little 
liquidity. There is not much that the Federal Reserve can do by 
adding reserves or lowering interest rates. The last time they 
tried it, $600 billion was added; $500 billion ended up in 
excess reserves. Don't the Chairman and several members 
understand that there are limits to what the Federal Reserve 
can do?
    Banks hold more than $1.5 trillion of idle reserves. Money 
growth, M2, for the past 6 months is rising at an almost 15 
percent annual rate. I attached a chart to my paper, or asked 
the staff to do that. Here is the chart, and it shows the 
enormous increase recently in the rate of increase in M2 
growth. Inflation, as a result, has begun to rise. Prices are 
rising, and the U.S. dollar continues to sink.
    The most useful action that the Federal Reserve could take 
would be announcement of an enforceable inflation target that 
would give confidence that we will not inflate.
    Third, in 1977, Congress gave the Federal Reserve a dual 
mandate, interpreted as low unemployment and low inflation. It 
pursues these goals in an inefficient way by pursuing 
unemployment until inflation rises, shifting to inflation 
control until unemployment rises, and back and forth. That way, 
it achieves neither.
    The ``Great Inflation'' of the 1970s is an extreme example. 
Both unemployment and inflation rose. The current Fed repeats 
that pattern. In contrast, policy from 1985 to 2003 more or 
less followed a rule that included both goals. That gave the 
public one of the very few years of low inflation and stable 
growth in the Fed's 100-year history.
    In Article I, Section 8, our Constitution gives Congress 
ultimate control of money. It should legislate an enforceable 
inflation target. I will amplify ``enforceable'' if you wish.
    Now, the three questions that the hearing has asked me to 
address.
    First, given the fiscal policy of the industrial nations, 
will government debt crowd out private investment? My answer is 
``yes.'' Today's deficits and debt raise concerns about future 
tax rates. The prospect of higher future tax rates raises the 
rate of return that business investors expect to earn on new 
investment. And uncertainty about future tax rates and the 
persistent increase in regulation of health, labor, and energy, 
and finance has deterred investment and slowed recovery. Faced 
with heightened current uncertainty, many investors hold cash 
and wait. Cash is their friend.
    Government budget and regulatory policies deter and crowd 
out investment. One of the most effective things that the 
Congress could do was to pass a moratorium on new regulation 
for the next 5 years, excepting national security.
    Vice Chairman Brady. Dr. Meltzer, the 5-minute time limit 
has expired. Would you conclude your testimony? And we will 
have a chance during questioning to pursue further.
    Dr. Meltzer. Yes.
    Let me say only this about the tipping point. Why wait for 
a tipping point and a crisis?
    We know that the debt is now a hundred percent, 
approximately a hundred percent, of GDP. That doesn't include 
the unfunded liabilities. It doesn't include Fannie Mae and 
Freddie Mac. It doesn't include a number of other things.
    So there isn't a point that we can mark down and say, after 
this crisis occurs. We don't know when crises will occur. And 
the experience of Italy and Greece, especially, recently tell 
us that the market suddenly changes its mind without warning 
and without prior notification. So we shouldn't wait for that 
to happen. We should begin.
    We have ample warning that we are on an unsustainable path. 
That unsustainable path--to respond to Congressman Cummings, is 
to say that we need to announce a plan that will reduce the 
deficit in a credible way, not beginning by taking everything 
off the table today, but announcing a plan which will put us on 
the path that we have to be on if we are going to restore the 
long-term growth rate of the United States with low inflation.
    [The prepared statement of Dr. Allan H. Meltzer appears in 
the Submissions for the Record on page 36.]
    Vice Chairman Brady. Thank you, Doctor.
    And I should note that all of the testimony of the three 
witnesses will be submitted in full in the testimony.
    The chair recognizes Mr. Edwards, 5 minutes.

STATEMENT OF MR. CHRIS EDWARDS, DIRECTOR OF TAX POLICY STUDIES, 
                 CATO INSTITUTE, WASHINGTON, DC

    Mr. Edwards. Thank you very much, Vice Chairman Brady and 
members of the committee.
    Federal spending, as you know, has soared over the last 
decade. And looking ahead, the CBO projects that Federal 
spending will rise from 24 percent this year to 34 percent of 
the economy by 2035 unless we make some serious reforms. And as 
your chart showed, the Federal debt, according to the CBO, will 
explode to almost 200 percent of GDP by 2035 unless we make 
reforms.
    Now, some people and economists think it is okay if America 
raises taxes and spending in coming years because they think we 
have a uniquely small government in this country, but that is 
really no longer the case. If you look at OECD data, total 
Federal/State/local spending in the United States now is 41 
percent of GDP. That is only 4 percent less than the OECD 
average spending now of 45 percent of GDP. We used to have a 
10-percentage-point-of-GDP advantage in terms of a smaller 
government, so that has shrunk now from 10 down to 4 percent. 
So, sadly, we are becoming just another sort of an average, 
bloated welfare state, which I think is really going to damage 
our economy.
    And if you look at debt, I think one of your charts showed 
United States Federal debt, gross debt, at 101 percent of GDP 
now, higher than the OECD average of 78 percent of GDP. And if 
you look at growth and debt over the last 4 years, our debt has 
grown the sixth fastest out of the 31 OECD countries. So, you 
know, there are a lot of debt crises going on in Europe, but we 
are certainly getting up to that level of fiscal 
irresponsibility.
    Without reforms, government spending may represent about 
half of GDP by 2035, which, in my view, would create a dismal 
future for young Americans, with fewer opportunities. I think, 
historically, our high standard of living has been based on a 
relatively smaller government, and it would be really sad to 
lose that.
    In my view, there are three basic harms of all this--that 
all this deficit spending creates.
    The first basic harm is that additional spending, in my 
view, sucks resources out of the more productive private-sector 
economy, puts it in the less productive government sector of 
the economy. Again, if the government in America is already 
spending 4 out of every 10 dollars, it seems to me that 
marginal spending in the government sector is going to have a 
lower negative return.
    In a 2008 book, Texas A&M public finance professor Edgar 
Browning, he went through the whole Federal budget, looked at 
Federal spending, and he figures that the extent of Federal 
spending we do these days in the United States has lowered 
overall average incomes by about 25 percent. So we are above 
the tipping point or optimal level for the size of our 
government in terms of economic growth.
    The second basic harm that all this deficit spending is 
doing, of course, is creating deficits, which are essentially 
deferred taxes that will pinch the economy down the road. 
Economists look to the distortions caused by the Tax Code as 
damaging the economy. This is called deadweight losses. When 
you raise taxes, you create more distortions in the economy, 
which reduces GDP.
    And the third harm of all the deficit spending is the high 
debt itself, as we are seeing, is creating financial 
instability and economic uncertainty. And we can certainly see 
this in Europe. A number of economists now have written about 
how 90 percent seems to be sort of a tipping point for debt as 
a share of the economy, and, above that, economic growth starts 
to slow.
    And here is what I think a lot of people are missing in 
this debate. When you look at those long-term CBO projections--
I think you had some on your charts--that show the rising debt 
and rising spending, it looks bad enough, but it is actually 
worse than that, because in CBO's basic alternative fiscal 
scenario, their basic benchmark projection, they don't take 
into account the fact that the rising debt and spending 
suppresses GDP.
    In a special analysis, the CBO looks every year at how that 
rising debt suppresses GDP, and it is pretty scary. It could 
well be, according to the CBO under some of its scenarios, that 
real U.S. incomes rise for the next decade or so but then they 
stagnate and then they start falling. This would be sort of a 
reversal of American history if American incomes actually 
started falling over the long term.
    Last year, CBO compared Paul Ryan's roadmap, which sort of 
keeps spending at today's level, versus the sort of do-nothing 
alternative fiscal scenario. And they found, by the 2050s, U.S. 
average incomes would be 70 percent higher under the Paul Ryan 
roadmap plan than under the alternative fiscal scenario because 
of the buildup of debt.
    Some fear, of course, that spending cuts in the short term 
would hurt the economy. I would only point out that, you know, 
we have had $5 trillion of deficit spending since 2008, the 
most enormous sort of Keynesian stimulus you can imagine, and 
yet we have the slowest recovery since World War II. So I don't 
think spending helps.
    And I think if you look around the world at real-world 
examples--your staff has put out a useful study looking at 
Canada and Sweden and other countries that have cut their 
spending. Canada, for example, dramatically cut their spending 
in the mid-1990s, and it didn't depress the economy. Quite the 
reverse: The Canadian economy boomed for 15 years even as 
spending was cut pretty dramatically.
    So, you know, I think Congress should turn its attention to 
major spending cuts as soon as we can. And, you know, at Cato 
we have all kinds of ideas for cutting every Federal Government 
department. I don't look at spending cuts as sort of painful 
medicine that we should fear; I think it would be a positive 
boom for economic growth.
    Thank you very much.
    [The prepared statement of Mr. Chris Edwards appears in the 
Submissions for the Record on page 39.]
    Vice Chairman Brady. Thank you, Mr. Edwards.
    The chair recognizes Dr. Ball for 5 minutes.

 STATEMENT OF DR. LAURENCE BALL, PROFESSOR OF ECONOMICS, JOHNS 
               HOPKINS UNIVERSITY, BALTIMORE, MD

    Dr. Ball. Vice Chairman Brady and members of the committee, 
thank you for this opportunity to share my views on U.S. fiscal 
policy.
    Other witnesses have emphasized the dangers of rising 
government debt, and I agree that reforms are needed to put 
debt on a sustainable path. I will focus, however, on a 
different side of the issue: the costs of controlling debt by 
cutting government budget deficits. And here, this will be 
largely elaborating on a point raised by Congressman Cummings. 
I will argue that cutting deficits reduces economic growth and 
raises unemployment in the short and medium run. These costs 
are especially large if deficit reduction is too hasty and 
occurs during an economic slump.
    Now, opinions about the short-run effects of fiscal policy 
vary widely, as we all know. Most economics textbooks teach 
that a fiscal tightening slows the economy by reducing the 
demand for goods and services. Some economists disagree with 
this view, suggesting that tightening is expansionary because 
it boosts confidence in the economy.
    Both sides of this debate have reasonable arguments. If we 
want to know who is right, we have to look at the evidence. 
And, in my view, the evidence is clear: Cuts in budget deficits 
have adverse effects that last for 5 years or more. If Congress 
cuts spending or raises taxes today, its actions will slow 
economic growth and raise unemployment until at least 2016.
    Now, this conclusion is supported by numerous studies--
admittedly, not all studies. I will focus on research performed 
over the past 2 years at the International Monetary Fund, work 
that many economists view as the best available evidence on the 
effects of deficit reduction. My written testimony describes 
this research in detail. In these remarks, I will summarize it 
briefly.
    IMF researchers reviewed the history of 15 countries over 
the period from 1980 through 2009. They identify a total of 173 
years in which governments reduced budget deficits through 
spending cuts, tax increases, or a combination of the two. The 
research finds that, on average, a deficit reduction of 1 
percent of GDP raises the unemployment rate by four-tenths of 
percentage point after 2 years, and unemployment is still two-
tenths of a point higher after 5 years. An important detail is 
that higher unemployment results mostly from higher long-term 
unemployment, meaning workers without jobs for 26 weeks or 
more.
    Making matters worse, these average effects of deficit 
reduction are likely to understate the effects in today's U.S. 
economy. In a typical episode studied by the IMF, a country's 
central bank responds to fiscal tightening by reducing short-
term interest rates, and this monetary easing dampens the rise 
in unemployment. Currently, the Federal Reserve cannot reduce 
rates because they are already near their lower bound of zero. 
In this situation, the evidence suggests that the costs of 
deficit reduction are about twice their normal size.
    To better understand these findings, let's consider one 
hypothetical fiscal policy: a deficit reduction of 3 percent of 
GDP. I picked this number because the Congressional Budget 
Office forecasts deficits of about 3 percent of GDP from 2014 
through 2020. With a 3 percent cut, deficits would fall to 
roughly zero.
    How would this policy affect unemployment? The evidence 
says a deficit cut of 1 percent of GDP raises unemployment by 
about 0.8 percentage points when interest rates are near zero. 
This means the 3 percent cut in my example would raise 
unemployment by 2.4 percentage points. With a U.S. labor force 
of 150 million people, an additional 3.6 million Americans and 
their families would suffer the consequences of a lost job.
    Let me mention another important finding of the IMF study. 
Recent political debates have focused on the choice between 
deficit reduction through cuts in government spending and 
through tax increases. This choice, of course, matters a lot to 
the beneficiaries of government spending and to people who pay 
taxes. In one way, however, this choice is not important. The 
IMF performed separate analyses of spending cuts and tax 
increases and finds that the adverse short-run effects on 
economic growth and unemployment are similar in the two cases 
if interest rates are near zero.
    Now, the question, of course, is, can any policy rein in 
government debt without slowing the economy? And a possible 
answer is a fiscal consolidation in which spending cuts and tax 
increases are back-loaded in time. And, again, I think this is 
related to Congressman Cummings' idea of something which is 
more stimulative in the short run but gets debt under control 
in the long run.
    Under such a policy, the government would commit to lower 
deficits in the future without sharply cutting the current 
deficit. Just as one example of how this might be done, one 
could imagine cost-saving changes in entitlement programs, such 
as a higher retirement age, that could be phased in over time.
    With any luck, major spending cuts would occur only after 
the economy has recovered from its current slump. Deficit 
reduction will be less painful then, in part because interest 
rates will be above zero and the Federal Reserve could ease 
monetary policy.
    And let me thank you again for your attention.
    [The prepared statement of Dr. Laurence Ball appears in the 
Submissions for the Record on page 48.]
    Vice Chairman Brady. Well, thank you all for your testimony 
today. And we will begin a round of questioning.
    The question today, posited by Senator DeMint, is, what is 
the real debt limit for America? And the answer seems to be, it 
is dangerously near and not in our control. As Dr. Meltzer 
said, market perceptions and actions change quickly, and 
countries that act prudently ahead of the crisis are in a 
better position.
    And my question to Mr. Edwards and Dr. Meltzer is, do you 
think there are some lawmakers in Washington in denial about 
the seriousness of our debt crisis? Because, temporarily, the 
costs of borrowing for this country are low, are being masked 
by outside--well, both inside and outside, the Fed's 
quantitative easing, lowering of interest rates, European 
crises which create a flight to safety, so our borrowing costs 
are temporarily lower.
    Do you think that, once the true costs of America borrowing 
are revealed, that there could be a more serious action by some 
in Washington to get this debt crisis under control? Dr. 
Meltzer? Mr. Edwards?
    Dr. Meltzer. I believe that steps that have been taken are 
preliminary steps--that is, to get $1.5 trillion or $1.2 
trillion in reductions is just the beginning.
    What we need to do is to give people confidence that their 
future is going to be bright. We don't do that by throwing a 
few dollars at them. We do that by giving them care that we are 
on a stable path, that we are going to go back to the future 
the way we knew the past.
    And that means that when, unlike Mr. Ball, models like the 
IMF model leave out is the fact that if you move resources from 
low-productivity goods--you know, it may be very desirable for 
people to receive transfers from the government. I don't 
dispute that. But those have very low productivity use. If we 
transfer resources to higher-productivity use, we raise the 
future and their optimism. If we cut the deficit, we convince 
people that their tax rates are not going to be higher in the 
future.
    The IMF model doesn't allow for that. It doesn't take into 
account the productivity change, and it doesn't take into 
account the beneficial effects of expected lower tax rates. 
Those are important conditions.
    Let me close by comment by saying two things. If we look at 
the history of the postwar period, we find that there were 
three fiscal changes that really did enormous good. One was the 
Kennedy-Johnson tax cuts. Arthur Okun, who was the Chairman of 
the Council of Economic Advisers, said the most effective part 
of those tax cuts were the business tax cuts. They got the 
biggest bang for the buck.
    The second big fiscal change that worked well were the 
Reagan tax cuts of the early 1980s and again in 1986. And the 
third policy that gave people confidence were the Clinton tax 
increases, which assured people that their future tax rates 
were not going to go up, that they had seen what they were 
going to have to pay and there wouldn't be any more.
    That is important. Give people confidence. That is what the 
public desperately needs at the moment, confidence that the 
policies that the government puts out are going to be 
sustainable and productive.
    Vice Chairman Brady. Thank you, Doctor.
    Mr. Edwards.
    Mr. Edwards. Yeah, I think your question goes to the right 
point, that because the United States is special, because we 
are a haven for international capital in a dangerous world, 
American policymakers have been able to get away with running 
giant deficits for far too long. I think if we were a smaller 
country like Australia, the crisis from our debt would have 
already happened.
    I noticed in a story yesterday on Bloomberg, Italy has just 
been downgraded. And one of the things that I think it was S&P 
noted is that they have been downgraded partly because they 
have a dysfunctional political system. And that seems to be 
sort of what is going on in the United States.
    Canada, again, to go back to the 1990s, hit the wall with 
their debt at 80 percent of GDP. Ours is up to 100 percent of 
GDP. So we have been skating along for so long, I think, partly 
because we are in this special situation. And Japan shows that 
you can run along sort of as a zombie economy for a decade or 
two with debt at 200 percent of GDP.
    So, you know, the real damage, though, I think, you know, 
is ultimately the spending. We have to get the spending under 
control. And that has been the key to success in places like 
Canada and Sweden that have cut their deficits.
    Vice Chairman Brady. Thank you. The point, I think, from 
both being: The key is to restore consumer and business 
confidence by getting our financial house in order with a 
credible way to shrink the size of government to restore that 
balance.
    Mr. Cummings.
    Representative Cummings. Thank you very much, Mr. Chairman.
    Just adding on to what was just said by Mr. Brady, Dr. 
Meltzer, did I understand you correctly to say--when you talked 
about when President Clinton raised the taxes, you said--you 
didn't see that as a negative thing. You saw it, in a way, I 
think--now, correct me if I am wrong--as something that created 
a level of certainty. And you are saying that the certainty is 
more important than some other factors? Is that accurate?
    Dr. Meltzer. Well, let me say, he also had the benefit of 
the end of the cold war.
    Representative Cummings. We really want to hear this. Is 
your microphone on?
    Dr. Meltzer. Sorry.
    Representative Cummings. Yes, don't go silent on me.
    Dr. Meltzer. He really had the benefit of the end of the 
cold war. So he was able to cut spending. And he was able to 
cut--he had Mr. Rubin there. Mr. Rubin, being a finance person 
from Wall Street, told him, don't run deficits. And he didn't 
run deficits, and he gave people confidence.
    Now, does that mean that a tax increase now would do what a 
tax increase then did? I don't believe so.
    Representative Cummings. Okay.
    Well, let's pick up on that, Dr. Ball. In 1999, postwar, 
middle-class incomes peaked. And, by the way, during that 
Clinton era, we produced some 22 million jobs. Since 2000 they 
have steadily declined, notably notwithstanding the 
implementation of historically low tax rates due to the passage 
of the 2001 and 2003 Bush tax cuts. This reversal of growth has 
led some economists to describe the time period between 2000 
through 2010 as ``the lost decade'' for America's middle class.
    Therefore, I find particularly troubling your findings that 
the government-imposed austerity measures during economic 
downturns have lasting negative impacts on economic and 
employment levels and that the bulk of these negative effects 
falls on middle-class and working people. Specifically, I am 
concerned that, if the Select Committee on Deficit Reduction 
achieves the required $1.2 trillion in savings only through 
spending cuts, rather than through a balance of revenue and 
cuts, this could result in a lost lifetime for millions of 
Americans--for example, those who are 5 or 10 years away from 
retirement.
    Dr. Ball, if throughout the last decade working Americans 
have watched their incomes stagnate or spiral downward and 25 
million more Americans are unemployed or underemployed, are you 
concerned about the detrimental impact that the $1.2 trillion 
in cuts could have on America's workers and middle class? 
Particularly in the context of the recent report that in 
America we have now 46.2 million people living under the 
poverty level, meaning $22,000 for a family of four?
    Dr. Ball. Absolutely, I am very concerned about that. There 
has been this stagnation of middle-class living standards that 
has a variety of causes. But there is no question that a harsh 
fiscal contraction right now would exacerbate that.
    One thing I didn't have time to mention in my testimony was 
another research finding, is that if you look at how total 
income of the economy goes down when there is a cut in 
government spending, it is disproportionately labor income or 
wages as opposed to capital income. So there is every reason to 
think that there would be a shift in the income distribution 
away from workers, as well as a fall in total income.
    And, as far as unemployment I don't think anybody really 
needs a lecture on how terrible a problem unemployment is. And 
there is a lot of research, but, again, it is also pretty 
obvious that losing your job is especially difficult, 
especially terrible during an economic downturn because then it 
takes a long time to find a new job. We have almost half the 
unemployed who are unemployed for 6 months or more. And I could 
go in to some of the social science research about the damage 
that does to families, health, divorce, children's performance 
in schools, but I am sure all of you understand that.
    Representative Cummings. Let me ask you this. You know, we 
constantly hear, get rid of this regulation, get rid of that 
regulation. You know, I wonder, when we get rid of all these 
regulations, does that guarantee that jobs are going to be 
added? In other words, you make it easier for the employer--you 
take away safety measures, in many instances, from the public--
easier to make more money, but is that a guarantee that we will 
then see jobs expand?
    Dr. Ball. No, absolutely not. I mean, again, on any given 
regulation, there are a lot of pros and cons about the costs 
and benefits, but as a way of dealing with the current slump 
and 9 percent unemployment, that is really, honestly, a non-
factor, because what we have is a classic shortfall of demand.
    Normally when that happens, historically, the Federal 
Reserve has dealt with that by cutting interest rates and, if 
the economy doesn't recover, cutting interest rates some more. 
What is uniquely problematic about the current situation is 
that interest rates have hit zero, so the Fed has run out of 
ammunition, at least its usual kind of ammunition. And we need 
to somehow be creative and think about some other way to get 
firm spending on investment and to get consumers spending.
    Representative Cummings. Thank you, Mr. Chairman.
    Dr. Meltzer. Congressman Cummings, may I add to that? May I 
add to that?
    Vice Chairman Brady. Briefly, Dr. Meltzer, yes.
    Dr. Meltzer. Yes, briefly.
    Cutting regulation and giving people assurance about future 
taxes does a great deal. What it does is, if you are a 
businessman and you want to invest, the first thing you do, you 
learn in business school, is go out and figure out what the 
expected rate of return is going to be. You can't do that, 
because every day or every week there are new regulations--for 
health care, for finance, for labor, also for environment--and 
the President is out campaigning for higher tax rates. So you 
don't know what you are going to face, and so you sit on a 
bundle of cash and wait.
    We have never seen so much cash in the hands of banks and 
businesses as we do now. So we have to ask ourselves, why is 
that? And the answer is, because they are dreadfully uncertain 
and lack confidence about what the future is going to be. They 
don't know what that future is, and they can't estimate what 
the expected rate of return is.
    If they invest, they create jobs. Most of the jobs that are 
created are created by firms that start up and in the first few 
years hire and expand.
    Vice Chairman Brady. Thank you, Dr. Meltzer.
    Senator DeMint.
    Senator DeMint. Thank you, Mr. Chairman.
    Dr. Ball, you have referenced an IMF study a number of 
times. Is it fair to assume that the study includes many 
nations with government workforces that are a larger percent 
than the U.S.?
    Dr. Ball. Yes.
    Senator DeMint. So, then, is a determination of when you 
are cutting government spending, that those nations would 
likely have a higher unemployment because of that, because that 
spending directly affects the government workforce?
    Dr. Ball. I don't quite think that follows. The study is 
very careful in trying to measure, if we have a spending cut of 
a certain percentage of GDP, what are the average effects on 
output and unemployment.
    Senator DeMint. What we have seen with our deficit spending 
over the last few years, generally it is maintaining government 
employees at the State levels--teachers, others. But it would 
just seem to me, if your hypothesis that deficit spending is 
good for the economy and cutting that spending would cause 
higher unemployment, that using a study where most of the 
nations have a greater percent of government workers as part of 
the workforce, it may not necessarily be accurate.
    And do you not see the American economy, our free-market, 
capitalist system, as somewhat different than most of the other 
nations in the world?
    Dr. Ball. Well, I mean, this study includes Canada. It 
includes a variety of most of the world's advanced countries.
    Senator DeMint. Right.
    Dr. Ball. And I think--I mean, that is an interesting 
thing--that they could follow up, looking at different types of 
economies. But I think we are talking here about fairly general 
principles of economics that I would think apply to Europe, to 
Australia, to the U.S.
    Senator DeMint. Well, one of the challenges we have here is 
I think there are a lot of folks that want us to be more like 
European economies that are centrally planned. That is part of 
our different world views that we are dealing with right here.
    But let me just--maybe a question to the whole group. And, 
Mr. Edwards and Dr. Meltzer, maybe I will go to you first on 
this. But we are clearly in uncharted territory right now.
    Dr. Meltzer. Yes.
    Senator DeMint. We can have different opinions about that. 
But the Federal Reserve interventions are unprecedented. 
Stimulus spending is at unprecedented levels. The bleak and 
unsustainable fiscal outlook that we are dealing with is 
unprecedented. The weak and almost nonexistent recovery, 
despite the incredible levels of stimulus spending, is 
unprecedented.
    So how do these factors affect the nearness to the tipping 
point? And I know we can't determine exactly where that is. But 
I am wondering, where are we going to borrow the money from? We 
are projecting a trillion dollars a year, about, that we have 
to borrow or print. Where is that going to come from? And 
aren't we in such uncharted territories now that we need to do 
more than just sound an alarm, or am I just unnecessarily 
seeing a bleak situation?
    And, Mr. Edwards, I will start with you.
    And, Dr. Meltzer, I would like to get your opinion very 
quickly, too, if I could.
    Mr. Edwards. Yeah, I mean, we don't know where the tipping 
point is, where the next financial crisis is. I mean, recent 
academic research by Rogoff, Reinhart, and others points out 
that different countries are hitting that sort of wall in 
different sorts of places.
    As I mentioned, I mean, Japan's debt is 200 percent of GDP 
and has been for a couple decades. They are in a unique 
situation because most of their savings to finance that debt 
comes domestically. So we are not in that, you know, lucky 
camp. Half of our borrowing now comes from abroad. That is a 
real problem, as the CBO points out in their long-range 
projections. That means that, in the future, if we keep this 
up, we will be producing GDP but a bigger and bigger chunk of 
that GDP won't be going to Americans; it will be going to 
foreign creditors. So that is why our standard of living will 
be suppressed by this buildup of debt.
    I must say that, you know, hitting the tipping point 
isn't--I mean, that is not the end of the story. Ireland hit 
the tipping point, but recent news reports are indicating that 
they have taken some very good policy actions, cutting 
spending, and they are on the brink of recovery. They are in a 
much different situation than Greece, even though both of those 
countries had these massive spikes in debt. Ireland has taken 
the right policy courses, and they are headed now in the right 
direction.
    So, again, I don't think the biggest issue facing you is 
where the tipping point is. I think it is just, you know, 
stopping the bleeding as soon as we can.
    Senator DeMint. Dr. Meltzer, quickly--I am almost out of 
time--just a comment?
    Dr. Meltzer. Let me just say that Ireland did not have a 
large debt. It got a large debt because it assumed the debt of 
the banking system. It was a private debt. It assumed it as a 
public debt. That was a huge mistake that got Ireland into a 
problem.
    Take the case of Italy, which is a good case for us to 
study because it went along for decades with low growth and 
high deficits over 100 percent. When it jointed the ECB, it hid 
some of its debt, but it was basically over 100 percent, 
instead of the 60 percent that was required. Suddenly, that 
same situation gave rise to a loss of confidence. That was the 
tipping point. Why didn't it occur 2 years, 5 years, 10 years 
earlier? I don't think anyone can answer that.
    Senator DeMint. Thank you.
    I yield back.
    Vice Chairman Brady. Thank you, Senator.
    Representative Mulvaney of South Carolina is recognized.
    Representative Mulvaney. Thank you, Mr. Chairman.
    Dr. Ball, I am going to take the unusual step of asking you 
some questions. I have learned not to get into a battle of wits 
when I am woefully underarmed. It has been a long time since I 
have taken economics, so I am going to ask a couple questions 
and try not to make too big of a fool of myself.
    But let me ask you this question to start off. Do you 
believe that there is such a thing as a tipping point in the 
size of this debt?
    Dr. Ball. Oh, absolutely. And I think probably all three of 
us agree there is a tipping point and we don't know where it is 
and it would be prudent not to find out. So by no means do I 
want to say that we shouldn't be very concerned about long-run 
sustainability.
    Representative Mulvaney. And that is sort of where I was 
hoping we could get. I think one of the things that all three 
of you could agree on is that, if we get past that point, it 
would be actually much worse than the situation we find 
ourselves in today. Is that a fair statement?
    Dr. Ball. Probably. I think, again, because the U.S. is 
special and this is unprecedented, when it would happen or how 
bad it would be--again, it is the kind of thing we don't want 
to learn about.
    Representative Mulvaney. And that is one of my frustrations 
with the classical Keynesians is that they seem to lack, in my 
opinion, a long-term outlook. We are always looking quarter to 
quarter, we are looking year to year; there is no long term. 
And you remember what Dr. Keynes' comment was regarding the 
long term that we are all dead.
    We have sat in this room this year with a board of experts 
regarding entitlements. And I am talking; there were two 
Republican witnesses, an independent witness, and a Democrat 
witness. And the window of opportunity that that broad group 
gave us to fix entitlements was someplace between 2 years for 
the most conservative and 5 years for the most progressive or 
liberal witnesses that we had.
    And one of my concerns is that when I read your analysis, 
when I read your testimony, is that we lack any type of mid- to 
long-term outlook; that we are simply looking at the next 
quarter in an effort to try and boost the GDP.
    You go to the end of your testimony, for example, you talk 
about why printing money, why expansionary policies might not 
have the same type of inflationary outcomes that we have seen 
or that many of us, including many of the members of this 
board, and I know Mr. Edwards and Dr. Meltzer fear, because you 
say that businesses generally do not monitor the Fed's balance 
sheet and they do not base their pricing decisions on changes 
in the monetary base.
    I used to run a business. I can assure you that I didn't 
watch the Fed Reserve and I didn't watch expansionary policies. 
But what I did watch was my costs. And when my costs went up, I 
had to raise my prices. And I can assure you, while I wasn't 
watching the Fed, the brokers in food and fuel certainly were. 
And as my costs went up because of expansionary policies, I had 
no choice but to raise my prices or to go out of business.
    You go back to the Weimar Republic. You saw a tremendous 
inflation--in fact, hyperinflation--without an overheated 
economy. It was driven entirely by the printing of money. There 
was high unemployment at that time. There was fairly low 
productivity. And what we had was--well, we had middling 
productivity but you had tremendous inflation.
    One of the things that I fear when I look at your proposals 
is that we are underestimating the risk of inflation and 
hyperinflation. Take a minute and tell me why I can sleep at 
night and I shouldn't be too worried about that.
    Dr. Ball. Well, first of all, on the fiscal issues, you 
talked about the long run and the short run. I think the quote 
about, ``In the long run, we are all dead,'' is something that 
people are a little bit embarrassed about now, because the long 
run is important.
    Again, I think there is a lot of agreement about the long-
run dangers of the debt. It is just, we need to be realistic 
about if we are very aggressive right now at cutting the debt, 
there will be major costs in the----
    Representative Mulvaney. If we believed that we were closer 
to the tipping point rather than further, if we believed that 
we were closer than you think that we may be--let's say that we 
are the 2 years, you are the 5 years--isn't it entirely 
rational for us to be taking the steps that we are proposing?
    Dr. Ball. Well, I think at some level the right steps are 
obvious, and maybe everybody could even agree. It is addressing 
the looming--I mean, there is the CBO chart of the debt going 
off. That is because of primarily entitlement programs. So, in 
a perfect world, Congress would get together and have a 
friendly discussion and figure out some nice moderate 
compromise on how to fix entitlement programs, and that would 
solve the long-term problem without giving a big negative jolt 
to the economy today.
    I mean, if we address the deficit just by willy-nilly 
spending cuts over the next decade, I mean, maybe--I am not 
going to say whether that is, overall, good or bad, but there 
are going to be--there is going to be higher unemployment. 
There are going to be costs. So we should be realistic about 
that.
    Representative Mulvaney. You mentioned--very quickly, I 
have just a few seconds--you mentioned willy-nilly cuts. I 
agree with you that simply going in and cutting randomly might 
have a different output than coming in and cutting 
specifically. The Canada example is one that several of you 
have mentioned. And there, if you go back and you look at the 
history, it appears as if their cuts focused primarily on 
wealth-transfer programs and not on infrastructure.
    Would you agree, sir, with the premise that cuts in wealth-
transfer programs might have less of an impact on employment 
than cuts to infrastructure spending?
    Dr. Ball. I think that is plausible because infrastructure 
spending has a substantial effect on employment.
    Let me say very briefly on the inflation issue, that is 
something where maybe I do differ from others. I think the 
fears of inflation really are quite unwarranted, and that is a 
bogeyman that doesn't really--again, without a long economic 
debate, I think historically in the U.S. inflation pressures 
have taken off when the economy is overheated. Unemployment has 
been low, so workers push for higher wage increases. Firms are 
straining their capacities, so they have more of an incentive 
to raise their prices. An overheated economy is obviously the 
last thing we need to worry about right now.
    Representative Mulvaney. Thank you, Doctor.
    Thank you, Mr. Chairman. Sorry to go over my time.
    Vice Chairman Brady. No. Thank you.
    Mr. Campbell of California is recognized.
    Representative Campbell. Thank you, Mr. Chairman.
    The subject of this hearing is something I have been 
talking about for some years: the real debt limit; and I have 
been saying that, although we have had a lot of debates and 
disputes here in Congress over the statutory debt limit, that 
the statutory debt limit is an arbitrary number, and the real 
debt limit is when we reach what we are all today calling as 
the tipping point. But the pushback I get on that from some 
people--and I would like to ask Dr. Meltzer and Mr. Edwards to 
respond to this--is that people say, well, we are really a long 
ways from that.
    Look at what is happening with Treasury debt today. Look at 
the 10-year Treasury dropping--I don't know where it is right 
now--right around 2--but dropping at some point below 1.9 or so 
forth. The auctions are going out. There is a tremendous 
appetite for Treasury debt. The interest rates on Treasury debt 
are dropping dramatically. And this is an indication that we 
are a long, long ways from that tipping point.
    Would either or both of you like to respond to that?
    Dr. Meltzer. First, I would say the size of the unfunded 
mandate, which is not included in most of the numbers we talk 
about--not in the 90 percent, not in the 100 percent--is six to 
seven times the size of the deficit, depending upon what 
interest rate you use to discount it back for the future. So 
that puts us at an enormous amount. It is just as the chart 
shows. Mr. Ball and I agree. It is the Medicare and Medicaid 
expenditure that is going to cause us the problems we have. 
Social Security is a minor but important part of the problem, 
but it pales in significance compared to Medicare and Medicaid.
    So there are lots of things we can do, and there are a lot 
of things we can do to Medicare and Medicaid that don't require 
taking away promised benefits to people but changing them. For 
example--and just one of many examples--we have to ask: Why do 
we spend about 50 percent of the Medicare money on people who 
are within 6 months of dying? Now, they don't all die. So, for 
some, there is a benefit. But there is no copay attached to 
that. If we attached a copay and graduate it according to 
income, we would reduce a lot of----
    Representative Campbell. Dr. Meltzer, just because of the 
time, how do you respond to those people that say, in spite of 
all this, that we have considerably more debt that we can run 
up and that the evidence of that is the appetite for and the 
low interest rate on Treasury bills?
    Dr. Meltzer. The reason we have the low interest rate is 
because the Fed enforces it. If you want to look at where the 
pressure is coming from, look at the fact that the dollar has 
depreciated by about 15 percent against a weak currency like 
the Euro and by an even larger percent against a weak currency 
like the Japanese Yen, that the most recent inflation number 
was 3.8 percent--well above the Fed's target.
    So I don't buy the argument that in a weak economy you 
don't get inflation. You gave the example of Germany. Spain at 
the moment has 20 percent unemployment. Prices are rising. 
Britain has a high unemployment rate. Prices are rising. So 
there are other sources other than the labor market to give you 
inflation. And we are going to get them.
    Representative Campbell. Mr. Edwards.
    Mr. Edwards. There are these gigantic negative risks out 
there that something big and bad is going to happen to the 
American economy. We don't know what it is. If you go back and 
look at the January, 2008, CBO projection, they didn't project 
a recession. They said, well, maybe a recession would happen. 
But they actually projected growth would be strengthening in 
coming years. So we are going to be surprised by the next big 
recession or negative factor.
    If you look at CBO projections, I mean, there are no 
recessions in their 10-year outlook. But what if we have a 
gigantic recession a few years from now, another major 
recession? Tax revenues would plunge again, unemployment comp 
costs would soar, a lot of policymakers would want to do 
another giant stimulus, and we would be in this spiral downward 
of debt and poor economic growth.
    So we have got to start planning now. The risk factors are 
all on the negative side. European countries have this horrible 
demographic problem--worse than ours. Their debt loads are 
going up. So the higher their debt loads become and the higher 
ours become, the more risk of an international sort of a 
contagion, the more we are all at sort of a tipping point. If 
Europe can go into another deep recession, it would cause a 
deep recession here. The risks are all on the ugly side.
    Representative Campbell. In my last 15 seconds, do any of 
you want to comment on the thing the Fed is discussing to 
change the maturities of the debt that they hold?
    Dr. Meltzer. It won't do much. They tried it back in the 
1960s. They had a big experiment. It didn't work. That is, 
their own research at the Fed said it didn't work. Why? Well, 
think about it. If you suppress long-term rates and raise 
short-term rates, what do you think the market people are going 
to do? They are going to go the other way.
    Representative Campbell. All right. My time is expired.
    Vice Chairman Brady. Thank you.
    The chair recognizes Dr. Burgess of Texas.
    Representative Burgess. Dr. Meltzer, you referenced just a 
moment ago about the costs of Medicare for patients in the last 
months, even weeks, of life. I will just tell you, as somebody 
who practiced medicine for a number of years, the principal 
problem we have there is the lack of transparency on the part 
of the patient. They don't tell us when that last 2 weeks 
begins. So it makes it very, very difficult for us to balance 
our decisions.
    Dr. Meltzer. Of course.
    Representative Burgess. But along that line, you talk about 
the cost drivers contained within Medicare and Medicaid and you 
talked about perhaps changing things so that they don't take 
away future benefits. I will submit within the health care 
realm there is probably $1.3 trillion in immediate savings that 
will not take away future benefits, and that would be to delay 
the implementation of the Affordable Care Act, which nobody 
seems to seriously consider when they have deficit commissions 
or talk to the President. Is that something that this Congress 
should take under serious consideration?
    Dr. Meltzer. Yes.
    Representative Burgess. Thank you.
    We also talked--and this is for any one of you--we talked a 
great deal about cash on the sidelines. I have talked to a 
number of my community bankers, not just in the August recess 
but going back this past year and a little bit longer. The 
community bankers tell me that they are hampered by the fact 
that they must keep their loan-to-deposit ratio under 80 
percent or they will invite a visit from some type of bank 
examiner, and that visit may not be pleasant. So they take 
pains to not go that last--to not touch that last 20 percent as 
a consequence. They are not making money on that 20 percent of 
deposits. The community is deprived of the loans that those 20 
percent of deposits could create.
    Do any one of you have a sense that that is a bigger 
problem than what has been talked about before?
    Dr. Ball. If I may comment, I think that is a problem. I 
think probably depressed lending by community banks is one 
factor holding back the recovery. And perhaps regulators could 
change their attitude a little bit or think of creative ways to 
encourage lending and perhaps help recapitalize community 
banks.
    Representative Burgess. But we have kind of gone the other 
way in the past 18 to 24 months; and rather than making the 
regulations, perhaps clarifying them even, we have made them 
more obscure, as has been previously mentioned. We frighten 
people with what is the future regulatory environment that they 
are going to encounter.
    Dr. Meltzer, is that one of the reasons this cash is 
staying on the sidelines?
    Dr. Meltzer. That is one of the reasons. That is generally 
regulation. As Speaker Boehner said so well in his speech the 
other day, you can move your plant to China, but you can't move 
it to South Carolina. That sounds funny, but at the same time 
it really tells us a serious thing about what regulation does 
to the attitudes of businessmen.
    Representative Burgess. And we are talking right now and 
the President is talking about raising taxes to create jobs, 
and yet this is the same White House that just this weekend 
said that Lockheed in Fort Worth can't sell F-16s to Taiwan.
    Their National Labor Relations Board said you can't build 
Boeing aircraft in South Carolina, and American Airlines 
biggest jet purchase in the history of the country, probably, 
is buying non-Boeing products for perhaps the first time in 
their company's history.
    American Airlines is buying non-American-produced jets.
    Eight to 18 power plants are going to close in Texas on 
January 1 because the Cross-State Air Pollution Rule is going 
to be a significant detriment on jobs.
    The Keystone Pipeline, argue the environmental effects one 
way or the other, but the White House simply will not make a 
decision, whether they say yes or no.
    Drilling in the Arctic for Shell Oil, they just will not 
make a decision.
    The problem, as I see it, is not that taxes are not high 
enough. It is that the White House is so risk averse, it is 
afraid to act.
    Do any of you have an opinion about that?
    Dr. Meltzer. I agree with that completely. You don't know 
what the future is going to be. Cash is your friend.
    Mr. Edwards. Just a general sort of a comment. There has 
been so much focus in the last few years by policymakers in 
Washington on macroeconomics--a misguided focus in certain 
ways, in my view. Microeconomics is extremely important. If you 
go back, for example, and look at what Margaret Thatcher did 
after a decade of stagnation in the 1970s in Britain, sure she 
got the macroeconomics in order, but she did a heck of a lot of 
on the microeconomic side. Tax reform, deregulation, 
privatization, all those things, it is hard to quantify the 
impact on the economy. But there is no doubt that fast-growth 
economies, they are getting both the macro and microeconomics 
right.
    Dr. Meltzer. I would like to second that. I worked with 
Mrs. Thatcher some of the time. She was a real leader. She was 
willing to make tough decisions.
    Representative Burgess. Thank you, Mr. Chairman.
    Vice Chairman Brady. Thank you.
    We are going to undergo a second round of questioning by 
Mr. Cummings and Senator DeMint.
    Mr. Cummings is recognized.
    Representative Cummings. Dr. Ball, to what extent are our 
current deficits being driven by slow economic growth and what 
impact would more robust economic growth have on our ability to 
reduce the deficits and rein in the debt? And the proposals--
the most recent jobs proposals that were presented by the 
President, I just wanted to know what your opinion of those 
might be and do you feel that they would be helpful, as many 
economists have projected?
    Dr. Ball. I think there is absolutely no question that the 
main driving force behind the big run-up in the budget deficit 
is the economic slump. Somebody else referred to lower tax 
revenues, higher unemployment insurance. It is a very strong 
economic regularity that deficits go up in recession. So we 
have had a big recession. And that is the main thing.
    The stimulus program added to the debt, but it was 
secondary just compared to the recession. And, absolutely, if 
we can find a way to restore robust growth, that is the best 
possible deficit reduction plan. Anything which retards growth 
is going to be somewhat self-defeating as far as the fiscal 
situation because of the effects of growth on the deficit.
    As far as the President's jobs plan, I haven't studied it 
in detail. It seems like a step in the right direction.
    It stills seems, frankly, we face a huge problem. Actually, 
whether it is the President's jobs plan or various deregulation 
or things the Fed can do, it is not clear that any of the 
measures we have are really sufficient, that we may have to 
either really try something more radical or accept that we are 
going to live with high unemployment for quite a while.
    Dr. Meltzer. Mr. Cummings, that jobs plan costs $200,000 
per job. My wife, who is not an economist, listened to that and 
said, why don't we pick the same people, give them $150,000, 
and we will be ahead of the game? We are not going to get out 
of this problem by spending $200,000 per job.
    Representative Cummings. So, Dr. Meltzer, you are saying 
that you can't--one of the things that has always bothered me 
about all of this is you look at something like infrastructure, 
and in Maryland they say we have got a sinkhole developing 
every 8 minutes.
    Let me finish, Dr. Meltzer. I see you shaking your head.
    Dr. Meltzer. I agree with that.
    Representative Cummings. Every 8 minutes. We have got 
bridges falling apart. I told some people the other day, you 
can erode from the inside. You can die from the inside. If you 
are not educating your people, if you are not innovative, you 
can't be competitive. So at what point--I mean, seems to me, 
you have got to spend carefully to get the economy going and 
get people moving--carefully--but at the same time you can't 
die in the process. Because by the time you get out of the 
mess, you don't have a country.
    Dr. Meltzer. I agree, Mr. Cummings.
    Representative Cummings. You agree with me?
    Dr. Meltzer. I agree the infrastructure in the United 
States is bad. I live in Pittsburgh. I will match you bridge 
for bridge, and I will have a whole bunch left over. So, 
absolutely. But if you think that you are going to take 
carpenters and bricklayers and convert them into road builders 
and bridge builders overnight, you are kidding yourself. 
Building a bridge is a big job, and it requires people who are 
trained in steel.
    The President says, well, just let's take some of the 
unemployed construction workers and make them road builders. 
Have you watched them build roads? They use heavy equipment. 
You have to learn how to drive that. That is not going to be a 
solution.
    I agree. We have a long-term problem of infrastructure, and 
we are to do what we can about infrastructure. That is a 
constructive thing. We have waited way too long to do something 
about it.
    Education. We really have tried with education. It is 
terribly important. The gap in incomes between the poor and the 
rich is driven mainly by the fact that technology has changed.
    I was a corporate officer or director. If you didn't have 
an education, you couldn't read the computer that was beside 
your work station, you swept the floor. That is a loss of 
people. We need to do something about that. I wish I thought I 
knew what we needed to do.
    Representative Cummings. Thank you very much.
    Vice Chairman Brady. Thank you.
    Senator DeMint is recognized.
    Senator DeMint. Thank you, Mr. Chairman.
    I want to thank Congressman Cummings and Dr. Ball for kind 
of presenting the alternative view today. Obviously, we have a 
big difference of opinion in Washington about what we need to 
do to fix the problem.
    I, frankly, don't think I am looking at this through a 
political prism. I am thinking of it as a guy who was in 
business for many years. I consulted with a number of other 
businesses. So my political perspective is really not a 
political perspective. And what I am looking at today, by any 
measure from a business perspective, our Nation is bankrupt, if 
you look at the balance sheet. We have got a negative cash flow 
projected continuously, indefinitely. Most of our operating 
capital is borrowed money. Every new program we suggest has to 
be borrowed or printed.
    So our fate is in the hands of our creditors. That is a 
worrisome situation. I don't know how we can get around that.
    And the solution, if you use a business parallel, the 3 
percent of Americans who make over $200,000 also happen to 
create most of our jobs and give the most to charity, provide 
60 percent of all investment capital. They happen to be the 
ones making things happen. Taking more money from them and 
giving it to the people who are creating the debt does not seem 
to be making a lot of common sense.
    So just like a business whose revenue is down and they 
decide the best way to get out of that is to raise their 
prices, that is what we are talking about doing here. Our 
business is down. Our revenue is down. So we want to raise the 
prices on who are effectively our customers, those who are 
creating the revenue for us. And that is a difficult thing to 
swallow when we know in economy--it may not be true in IMF 
economies, but we have got a economy where 3 percent of 
Americans are already paying over half of the taxes. They are 
the ones creating the jobs, providing the investment capital. 
Frankly, that is not going to solve our problem.
    If you look at the data for the last 10 years, the increase 
in our deficit is mostly attributable to an increase in 
spending, and that includes a lot of discretionary spending.
    Social Security has not contributed to our debt at all. In 
fact, if we hadn't borrowed $3.6 trillion from Social Security, 
we would be a whole lot more in debt than we are today.
    So this is not all on the entitlements. This is on a belief 
of government that we need to direct the economy. And I think 
the difference of opinion here is that the government is the 
primary stimulator of the economy versus those of us who think 
the reason America was so exceptional and prosperous was that 
we were a bottom-up economy with millions of people starting 
businesses, innovating, being entrepreneurs. Those are the 
people we seem to want to attack right now. Of those who have 
income over $200,000, 40 percent of their income is small 
business income.
    So I understand the need to balance revenue as well as 
spending cuts, but we can get new revenue by making the economy 
grow. Frankly, if you look at 20-year data, you can raise the 
taxes as much as you want, but the revenue is going to be about 
20 percent of our GDP--excuse me--18 to 19 percent of our GDP 
over time.
    So I appreciate all of our panelists helping us to talk 
through this. To me, this is a situation where, like all of you 
have said, let's not wait to find out. Because all this is 
going to take is China to say they are not going to lend us 
more money, to dump our debt at 80 cents on the dollar. And the 
faith that keeps us up--and that is what we do have to admit, 
that the only thing keeping our dollar up, keeping what economy 
we have going is faith and the fact that other economies are 
worse off than we are right now.
    But thank you for helping us talk through this. Mr. 
Chairman, to you and your committee staff, I appreciate all the 
work you have done. I appreciate all the folks who have 
answered questions, and I hope we will follow up with some 
decisive action that will solve our problem.
    Vice Chairman Brady. First, let me thank Senator DeMint for 
leading this hearing today and the members of the Joint 
Economic Committee, both parties, for engaging. I so much 
appreciate the insight and thoughts provided by our panelists 
as well.
    To borrow from the President's current speech, it is clear 
the real debt limit is upon us now. We have to act credibly to 
reduce that debt--and now--and we need to get Washington out of 
the way of our recovery now.
    With that, the meeting is adjourned.
    [Whereupon, at 11:21 a.m., the committee was adjourned.]

                       SUBMISSIONS FOR THE RECORD

Prepared Statement of Representative Kevin Brady, Vice Chairman, Joint 
                           Economic Committee

    When the Joint Economic Committee must hold a hearing on what the 
real debt limit is, the American people know instinctively that their 
federal government is borrowing too much. One does not really want to 
contemplate the grave consequences if creditors were to lose faith in 
the federal government to repay its debts.
    The United States supplies the world's primary reserve currency; 
has the world's largest economy; and is source of much of the world's 
technological progress and economic development. The federal government 
should never violate its real debt limit because the consequences of 
exceeding it would be calamitous not just for the United States but 
indeed the entire world.
    Nevertheless, the JEC must hold this hearing because the question 
now is asked: What is the real debt limit? Amazingly there are some 
that do not believe the U.S. has a serious debt problem. Given the 
anemic recovery, these individuals argue that President Obama's deficit 
spending splurge should continue. ``Don't worry because interest rates 
on Treasuries remain low, and the federal government can print more 
money to pay all its debts,'' they say.
    I hope that today's hearing sheds light on the fallacy of this 
mindset and puts an end to it.
    Keynesian theory tells us to ignore the level of federal debt and 
continue deficit spending until full employment has been achieved. 
Well, we simply cannot ignore the debt anymore.
    According to recent economic studies, when gross government debt 
relative to size of the economy exceeds a certain threshold, the 
economic growth and job creation slow dramatically. Economists Carmen 
Reinhart and Kenneth Rogoff put the threshold at 90%, while another 
study by economists at the Bank of International Settlements put it at 
85%. The page in the Keynesian playbook on what policymakers should do 
when gross government debt exceeds this threshold and high unemployment 
persists is--blank.
    Gross federal debt already exceeds 98% of GDP and is on course to 
exceed 100% next year according to the Congressional Budget Office 
(CBO). Now that we are staring at that empty page in the Keynesian 
playbook, we have to forge a new path.
    The dynamics of rising federal debt relative to our economy are 
dangerous. The federal government must stay clear of the undertow of 
deteriorating economic performance, rising interest rates, and higher 
tax rates.
    To begin, we must discard fiscal policies that have not been 
working. Economists John Taylor and Michael Boskin have detailed how 
the Obama ``stimulus'' and other federal spending were wasted on 
transfers that produced no lasting growth. We cannot afford another 
round of ``stimulus'' disguised as a ``jobs'' bill.
    Growth is what we need. In the following chart, the top line shows 
the gross debt-to-GDP ratios for the next ten years, as implied by 
CBO's projections since the Budget Control Act was adopted. The average 
annual growth rate during the forecast period is 4.2% for gross debt 
and 4.6% for nominal gross domestic product (GDP)--just slightly 
higher. This is why the ratio of the two ends close to where it starts. 
The blue line shows the ratio if the debt grew only 2% while nominal 
GDP grew 6% per year.

[GRAPHIC] [TIFF OMITTED] T1033.001

    The U.S. economy must grow significantly faster than federal debt 
to move the ratio down from the dangerous levels around 90%. In the 
CBO's outlook for the Administration's budget, that fails to happen; 
the spread in trajectories of debt and economic growth is too small.
    Viewed this way, it is obvious that the country's economic policies 
must change, and not only with regard to federal spending and 
borrowing. Myriad regulations that hamstring economic activity and 
discourage private investment must be reversed, and the anti-employer 
attitude must go.
    We know that entrepreneurs, investors, and consumers on Main Street 
fear the consequences of the rising federal debt. The real debt limit 
is upon us. We must act credibly to contain federal debt and release 
the private economy so that it can grow as it has in the past and how 
it must grow again.

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               Prepared Statement of Dr. Allan H. Meltzer
    Vice Chairman Brady, Senator DeMint, Members of the Committee.

    It is a pleasure to appear again before the Joint Economic 
Committee. My association with this committee goes back to the days of 
Senator Paul Douglas. It was Sen. Douglas who pushed and prodded the 
Federal Reserve to stop holding interest rates fixed and permit 
monetary policy to do much more to prevent inflation. His views 
eventually prevailed. That should remind the members of their 
responsibility.
    Today, I will answer the questions that this hearing topic seeks to 
address. The question of ``what is the real debt limit'' includes some 
good questions that show rising concern for the consequences of recent 
Federal Reserve actions. I will introduce my answers with my 
explanations of why Federal Reserve policy is misguided and mistaken, 
inflationary and inappropriate. There are several reasons. I will give 
three.
    First, in writing the three volumes of ``A History of the Federal 
Reserve,'' I read more minutes and transcripts than any person can 
endure. With very rare exceptions, notably in the years when Paul 
Volcker led the disinflation policy, one looks in vain for a statement 
of the medium-term consequences of the actions taken at the meeting. 
True, the staff and others provide forecasts of the future, but the 
FOMC never tries to reach agreement on the consequences of its actions 
for the public. It publishes forecasts but there is no clear relation 
between forecasts and actions.
    Second, concerns at FOMC meetings are mainly about the near-term. 
The Federal Reserve has little influence over what will happen in the 
near-term but much greater influence on the medium-term. The present is 
characteristic. The Fed Chairman and some of the members seem 
determined to ``do something'' more about the excessive waste and harm 
of high unemployment. They neglect the fact that there is no shortage 
of money and liquidity and that they have pushed and prodded market 
interest rates to the lowest levels ever achieved. THE UNITED STATES 
DOES NOT HAVE A PROBLEM OF TOO LITTLE LIQUIDITY. THERE IS NOT MUCH THAT 
THE FEDERAL RESERVE CAN DO BY ADDING RESERVES OR LOWERING INTEREST 
RATES. Doesn't the Chairman and several members understand that there 
are limits to what the Federal Reserve can do? Banks hold more than 
$1.5 trillion of idle reserves. Money growth (M2) for the past 6 months 
is rising at almost 15 percent annual rate. (See chart.) Prices are 
rising and the U.S. dollar continues to sink. THE MOST USEFUL ACTION 
WOULD BE ANNOUNCEMENT OF AN ENFORCEABLE INFLATION TARGET TO GIVE 
CONFIDENCE THAT WE WILL NOT INFLATE.
    Third, in 1977 Congress gave the Federal Reserve a dual mandate, 
interpreted as low unemployment and low inflation. It pursues those 
goals in an inefficient way by pursuing unemployment until inflation 
rises, shifting to inflation control until unemployment rises, and back 
and forth. That way, it achieves neither. The Great Inflation of the 
1970s is an example. Both unemployment and inflation rose. The current 
Fed repeats that pattern. In contrast, policy from 1985 to 2003 more or 
less followed a rule that included both goals. That gave the public one 
of the very few years of low inflation and stable growth in the Fed's 
100 year history. In Article 1, Section 8, our constitution gives 
Congress ultimate control of money. It should legislate an enforceable 
inflation target. I will amplify ``enforceable'' if you wish.
    Now to the more specific questions of the real debt limit.
    First, given the fiscal policy of the industrialized nations, will 
government debt crowd out private investment spending? My answer is 
yes. Today's deficits and debt raise concerns about future tax rates. 
The prospect of higher future tax rates raises the rate of return that 
business investors want to earn on new investment. And uncertainty 
about future tax rates and the persistent increase in regulation of 
health, labor, energy, and finance has deterred investment and slowed 
recovery. Faced with heightened, current uncertainty, many investors 
hold cash and wait. Cash is their friend. Government budget and 
regulatory policies deter, crowd out, investment.
    Second, the original Federal Reserve Act prohibited loans to the 
Treasury. Early in its history the Federal Reserve circumvented the 
prohibition by buying Treasury bonds from the market after the Treasury 
sells them. This monetizes debt. With the exception of wartime, the 
Federal Reserve bought mainly very short-term Treasury bills. In the 
1950s, it ran a ``bills only'' policy. Recently it has done what no 
central bank should do: It has implemented the government's fiscal 
policy by buying long-term Treasury bonds and $1 trillion worth of 
mortgage-backed securities. Ask them how they plan to sell mortgages in 
this mortgage market. The screams from homebuilders would be heard all 
across the country. A straightforward way of saying the same thing is 
that THE FEDERAL RESERVE DOES NOT HAVE A CREDIBLE PROGRAM FOR SHRINKING 
ITS BALANCE SHEET.
    If Treasury rates rise, the Federal Reserve portfolio will lose 
value. Until Dodd-Frank, 90 percent of the Fed's earnings became 
Treasury receipts, so the Treasury and the taxpayers bear the cost of 
the recent change. Dodd-Frank authorizes the new consumer agency to 
sequester Federal Reserve earnings without approval by the Congress or 
the Fed. I have been told that this off-budget finance is not 
unconstitutional. I continue to believe that the Congress should 
prohibit ALL off-budget finance. The constitutional provision that 
makes Congress responsible for spending should be strengthened.
    The question regarding the implications of our enormous debt has 
several parts. Some ask for more precise answers than anyone can give 
correctly.
    The ``tipping point'': Some authors say a ratio of 90 to 100 for 
government debt to gross domestic product (GDP) is a ceiling. Beyond 
the ceiling, interest rates rise suddenly because bond investors fear 
inflation, default, or sharply rising interest rates and losses in the 
value of bond holdings. We are there. Public debt is $14.7 trillion, 
and second quarter nominal GDP is $15 trillion. If we add, as we 
should, to the current U.S. government debt, the promises to pay 
obligations of Fannie Mae, Freddie Mac, the Federal financing bank and 
the unfunded liability for Medicare, Medicaid, and Social Security, the 
debt of the United States government passed the 90 percent ratio years 
ago. Currently, unfunded debt in the medical programs reaches $70 to 
$100 trillion, as much as 6 or 7 times the reported debt, depending on 
the rates used to discount future promises. The ``full faith and credit 
of the United States'' is stretched far above the ability to pay. Yet 
interest rates on government bonds are lower than they have ever been. 
There is no sign in current interest rates of the looming debt problem. 
Exchange rates tell a different story.
    Why wait for a ``tipping point'' and a crisis? We have ample 
warning that we are on an unsustainable path. We don't know when a 
crisis will occur, and we should not wait to learn whether it does. 
PRUDENT POLICY ANTICIPATES CALAMATIES BEFORE THEY OCCUR. RESPONSIBLE 
POLICY MAKERS DON'T WAIT FOR CRISES.
    Japan's outstanding public debt is at least double its GDP. 
Government debt for Italy and Belgium has long been above 100 percent 
of GDP. I do not know what unfunded liabilities may add to these sums. 
They suggest that we will not find a precise number like 90 percent of 
GDP to warn us of impending interest rate increases. But we also know 
from the recent experience of Greece and Italy that sudden changes in 
market perceptions occur. What was acceptable suddenly becomes 
unacceptable. This is a warning that prudent folks will heed.
    Perhaps we should see a warning in the fact that our debt and 
deficits are unsustainable. Every knowledgeable observer recognizes 
that. Why wait for a market crisis to tell us what we already know?
    At a time of considerable uncertainty about the future of 
currencies and economies, the large, open market for U.S. debt is a 
refuge for frightened investors. The Federal Reserve does not let 
interest rates increase, so holders think they are protected from 
losses caused by rising interest rates. Some hope for additional gains 
if the Fed lowers rates by making additional large-scale purchases. The 
result is that for the present holders are willing to accept negative 
real returns on their bonds. Negative real returns subtract the current 
inflation rate from the current market interest rate.
    Japan's relatively large debt is almost entirely owned by Japanese 
citizens. Unlike our current citizens, Japanese save and put much of 
their saving into Japanese institutions that buy government debt. The 
nominal interest rate on long-term Japanese debt has remained between 1 
and 2 percent for many years. Investors expect that pattern to 
continue, so there is no sign of an impending debt crisis. Japanese 
experience should not make us sanguine. We depend on the rest of the 
world to finance at least half our annual budget deficit. That's a risk 
for us but not for Japan.
    Italy is instructive. The debt-to-GDP ratio remained above 100 
percent for years. Italian savers bought a large part of the debt. As 
concerns about the future of the euro rose, Italian debt suddenly and 
unexpectedly rose in yield and fell in price. The European Central Bank 
made large purchases to reassure investors that there was a residual 
buyer. Uncertainty about what will happen in the future, not the 
distant future, remains.
    German and French banks hold large amounts of Italian debt. They 
would like a government bailout, so they pressure governments. 
Meanwhile, they sell as much of the Greek, Italian, and Spanish debt as 
they can.
    The sudden crisis affecting Greece and Italy teaches two things of 
value to us. One is market perceptions and actions can change quickly. 
The other is that prudent policy does not wait for the crisis. It acts 
before when many more options are available. It would be better to 
adopt Congressman Ryan's budget plan that leaves current and near-term 
health care beneficiaries unharmed than to wait for a crisis that 
forces much more immediate, drastic action and harms current 
recipients.
    If rates spike up, without warning, we will be forced to make 
sharp, sudden changes in spending and tax rates. The alternatives are 
default and inflation. Default would harm the credit of the United 
States for years, even decades. It should be unthinkable.
    Many now propose to ease the debt burden by raising the inflation 
rate to 5 or 6 percent. That would reduce the burden of long-term debt 
and mortgages, but it would raise interest rates for new debt issues 
and refunding. The average maturity of outstanding debt is between 3 
and 4 years, so we would face higher interest rate expense very soon. I 
would like the proponents of a higher inflation target to tell us how 
they propose to bring the inflation rate down in the future. It is 
unlikely that we can reduce inflation without causing a new recession. 
People invest expecting inflation to continue. Farmers borrow to buy 
land. Home builders suffer a collapse when disinflation raises interest 
rates. Moreover inflation will not put much of a dent in the enormous 
unfunded liability for health care. And it cheats the principal holders 
of U.S. debt, especially China and Japan, with unforeseen consequences.
    Recent unprecedented actions by the Federal Reserve solicit 
questions about limits to Federal Reserve monetary expansion. There are 
no legal restrictions. The only limit I know comes from the public. At 
some inflation rate, the public will demand less inflation. In 1979, 
inflation reached double digits. The public declared inflation to be 
the major economic problem. President Carter responded by appointing a 
known anti-inflationist, Paul Volcker. In his interview, Volcker told 
the president that he would reduce inflation. President Carter 
responded that was what he wanted. He had not taken effective action 
before, but he faced an election in which the public wanted lower 
inflation.
    Increasing inflation until the public responds is not the right 
answer. One part of the right answer is to reach a long-term budget 
agreement that brings government spending below sustained GDP growth. 
That will be difficult but there is much waste in health care and other 
spending. I will expand a bit if you wish. The other part of the right 
answer is to rein in the unrestricted power of the Federal Reserve by 
imposing an inflation target.
    And finally, what might be the consequences of adopting stabilizing 
policies? Ten years from now, we will export more and import relatively 
less. We will grow family incomes at about our long-term trend. 
Consumption will grow more slowly than in recent years because we must 
export more and import less to service the nearly $ 5 trillion of debt 
owed to foreigners. Foreigners will have to find a substitute for 
export-led growth because we can no longer be the importer of last 
resort. Of major importance for the future is the smaller role we will 
play in maintaining world peace. The United States cannot be the 
world's policeman. But political stability is vital. That's a big, 
separate set of issues that take us far afield.

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                Prepared Statement of Dr. Laurence Ball

    Chairman Casey, Vice Chairman Brady, and members of the Committee,
    I am grateful for the opportunity to discuss the challenges to the 
U.S. economy posed by the combination of rising government debt and 
high unemployment. I will also comment briefly on current Federal 
Reserve policy, which your committee is also considering.

                   THE COSTS OF FISCAL CONSOLIDATION

    Indisputably, Congress must address the problem of rising debt to 
prevent a fiscal crisis that could gravely damage the economy. How to 
solve this problem is a complex issue. We need policies that will keep 
debt on a sustainable path while providing essential government 
services and minimizing the economic distortions caused by taxation. I 
will not analyze all these issues or presume to say what fiscal 
policies Congress should adopt. Instead, I will focus on a more narrow 
question: What are the short- and medium-run impacts of fiscal 
consolidation--of cuts in government spending or tax increases--on 
economic growth and unemployment? Congress must understand these 
effects to choose the best response to rising government debt.
    Opinions about the effects of fiscal policy vary widely. Most 
economics textbooks teach that a fiscal consolidation slows the economy 
in the short run. Higher taxes or lower government spending reduce the 
demand for goods and services, reducing growth and increasing 
unemployment. Yet some economists and policymakers disagree with this 
view, suggesting that fiscal consolidations are expansionary. One view 
is that lower budget deficits strengthen confidence in the economy, 
leading to higher consumption spending and more investment by firms.
    Both sides of this debate present logical and plausible arguments. 
If we want to know who is right, we have to look at the evidence. 
Fortunately, history provides numerous examples of fiscal 
consolidations that we can study. And in my reading of the evidence, 
the verdict of history is clear: fiscal consolidations slow the 
economy, with adverse effects that last for five years or more. That 
is, if Congress cuts spending or raises taxes today, the consequences 
will include slower economic growth and higher unemployment than we 
would otherwise expect until at least 2016.
    Numerous studies (admittedly, not all studies) support the 
conclusion that fiscal consolidations are contractionary. I will focus, 
however, on several studies performed over the past two years in the 
Research Department of the International Monetary Fund. In my view, 
this work provides the best available evidence on the effects of fiscal 
consolidation, because of the wealth of data that it examines and its 
straightforward and compelling methodology. In addition, the expertise 
of the IMF's staff and its history of promoting responsible fiscal 
policy lend credibility to its analysis. (I should note that I am a 
part-time visiting scholar at the IMF, but not a lead researcher in its 
work on fiscal policy.)
    The basis of the IMF research is a painstaking review of history in 
15 countries over the period from 1980 through 2009. Based on records 
of fiscal policy decisions, the researchers have identified a total of 
173 years in which governments adopted policies to reduce budget 
deficits--either spending cuts, tax increases, or a combination of the 
two.
    Having identified fiscal consolidations, the IMF researchers 
measure the effects with very simple statistical techniques. They ask 
whether economic growth and unemployment were higher or lower after 
consolidations than one would expect based on their normal behavior. 
The central conclusions concern the average effects of consolidation 
across the 173 episodes. It is essential to average over many episodes 
to eliminate the influences of factors besides fiscal policy that may 
affect the economy in any one case.
    How does a fiscal consolidation affect growth and unemployment? The 
IMF research finds that a consolidation that reduces the budget deficit 
by one percent of GDP reduces future GDP by 0.6 percent after two 
years. The effect then diminishes, but GDP is still 0.4 percent lower 
after five years. The consolidation raises the unemployment rate by 0.4 
percentage points after two years and 0.2 points after five years.
    The research also finds that the effects of fiscal consolidations 
vary with economic circumstances. In particular, the average effects I 
have just cited are likely to understate the contractionary effects of 
consolidation in today's U.S. economy. In a typical episode in the IMF 
data set, a country's central bank responds to fiscal consolidation by 
reducing short-term interest rates, and this monetary easing dampens 
the effects of the consolidation. In the United States today, the 
Federal Reserve cannot reduce interest rates because short-term rates 
are already near their lower bound of zero. According to the IMF study, 
the effects of fiscal consolidation are about twice their normal sizes 
if interest rates are near the zero bound. This doubling means that a 
consolidation of one percent of GDP reduces GDP by 1.2 percent after 
two years and raises unemployment by 0.8 percentage points.
    What do these numbers mean? To understand them better, let's focus 
on unemployment effects and consider one hypothetical fiscal 
consolidation. The Congressional Budget Office forecasts that the 
budget deficit will be about 3% of GDP in 2014 and stay near that level 
through 2020. Suppose that Congress chooses to eliminate this 3% 
deficit: it cuts spending and/or raises taxes by a total of 3% of GDP, 
so the deficit settles near zero. What will happen to unemployment?
    As I have discussed, the IMF research suggests that a consolidation 
of one percent of GDP under current circumstances raises unemployment 
by 0.8 percentage points after two years. This implies that the 3% 
consolidation in our example would raise unemployment by 2.4 percentage 
points. With a U.S. labor force of 150 million people, an additional 
3.6 million Americans and their families would suffer the consequences 
of a lost job.
    Let me mention another important finding of the IMF study. Recent 
debates about U.S. fiscal policy have focused on the choice between 
deficit reduction through cuts in government spending and through tax 
increases. This choice matters greatly to the beneficiaries of 
government spending and to taxpayers. In one way, however, the choice 
is not important. The IMF researchers perform separate analyses of 
spending cuts and tax increases and find that the adverse effects on 
economic growth and unemployment are similar (at least in the case when 
interest rates are near zero).
    Is there any way to control government debt without harming the 
economy in the short run? The IMF's findings suggest a type of policy 
that could achieve this goal: a fiscal consolidation in which spending 
cuts and tax increases are backloaded in time. Under such a policy, the 
government commits to lower deficits in the future without sharply 
cutting the current deficit. An example is a cost-saving change in 
entitlement programs, such as an increase in the retirement age, that 
is phased in over time. Such a policy could put government debt on a 
sustainable path without raising unemployment sharply. By the time 
major spending cuts occur, we can hope the economy has recovered from 
its current slump and unemployment is lower. Spending cuts would be 
less painful at that point than they would be now. One reason is that 
interest rates would be above zero, allowing a monetary easing.

                          WILL INFLATION RISE?

    I have mentioned the fact that the Federal Reserve is holding 
short-term interest rates near zero--a highly unusual policy by 
historical standards. The Fed has also purchased large quantities of 
Treasury bonds and mortgage-backed securities, causing the monetary 
base to triple. Further asset purchases appear to be under 
consideration. Some economists and policymakers have expressed concern 
that these policies will cause inflation to rise to undesirable levels. 
Let me comment on this issue briefly, explaining why I believe that 
fears of inflation are unwarranted.
    At first blush, the Fed's near-zero interest rate target and its 
expansion of the monetary base are highly expansionary policies. In 
normal times, such policies would indeed cause inflation to rise. But 
these are not normal times.
    We need to remember why expansionary monetary policy normally 
causes inflation. Inflation occurs when businesses around the country 
raise their prices. These businesses generally do not monitor the Fed's 
balance sheet, and they do not base their pricing decisions on changes 
in the monetary base. Instead, monetary policy affects inflation 
indirectly, through its effects on aggregate spending. If policy is too 
expansionary, the economy overheats. Firms see their sales rise and 
their productive capacity is strained, and workers find that jobs are 
plentiful. Under these conditions, firms are likely to raise prices 
rapidly and workers push for large wage increases.
    Given this mechanism, inflation is a danger only if the economy is 
overheated--regardless of what the Fed is doing to its balance sheet. 
In today's environment, with unemployment above 9% and likely to stay 
high for years, an overheated economy is the last thing we should worry 
about. Some day the economy will recover and the Fed will need to exit 
from its current expansionary policy. But today's challenge is the 
terrible problem of 9% unemployment. Rather than scale back its 
policies, the Fed should redouble its efforts to stimulate the economy 
and push unemployment down.
  

                                  
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